Mercator Capital is a privately-held investment bank focused on mergers & acquisitions, private placements, and strategic advisory services. Mercator's IP Communications Newsletter is a monthly analysis and commentary on the major business stories impacting the convergence of voice, video, data, and wireless communications.

1. Mobile Disruption – 3 Skypephone

October 29 saw the announcement of Skype’s most ambitious foray into wireless voice to date. Skype has partnered with 3 Mobile, a 3G carrier and media company owned by Hong Kong-based Hutchison Whampoa to launch a new service called "3 Skypephone". 3 Mobile operates in Europe, Asia and Australia, and the 3 Skypephone service will launch first in the U.K. on November 2, then rolled out across their other markets.

This service is disruptive on a few levels, and has the potential to impact the mobile market in much the same way Skype has done with PC-based telephony. The first level of disruption is the simple fact that a mobile carrier of any kind has partnered to allow Skype traffic to traverse their network. Mobile carriers view VoIP and WiFi traffic as a threat to their revenues by diverting profitable calls off their network, in much the same way that upstarts like Vonage did to the RBOCs during the early days of VoIP.

Skype is not alone in this regard. In a broader context, mobile VoIP has been gaining momentum, which was most recently analyzed in the June issue where we evaluated Intel’s investment in Jajah. Several mobile VoIP plays are gaining traction, including Rebtel, Mino Wireless and TiVi (Tilts Visiem).

With Skype being a proprietary protocol, a variety of other offerings developed specifically around mobile Skype applications have come to market. Most notable among these are iSkoot, Truphone, Mobivox, Shape Communications, and until recently, EQO Communications.

These services extend the Skype experience beyond the desktop, and to varying degrees are designed to work with the handsets currently in use. While they help Skype build new revenue streams, they are not welcomed by mobile operators. This has been particularly problematic for Truphone, whose Skype traffic T-Mobile recently refused to carry. Truphone has since succeeded in challenging this blockage, and potentially represents a turning point for mobile VoIP.

Mobile operators are in fact, fighting a losing battle here. They wield an inordinate amount of market power across the wireless value chain, and many have been able to disable the WiFi features that are becoming increasingly common for mobile phones. This behavior does not serve the end user well, and will not be tolerated indefinitely. In this context, we see 3 Mobile’s partnership with Skype as a step forward.

The second disruptive aspect of 3 Skypephone is the product itself. 3 Skypephone is a 3G mobile handset, designed specifically to make Skype calls, which is an industry first. In addition to supporting regular cellular calls and mainstream features such as a camera, MP3 player, Web browsing and Bluetooth, this phone has one-touch dialing to make Skype calls. As with PC-based Skype, text chat and voice calls are free to other Skype users wherever they are. The revenue base comes from making long distance calls over Skype to non-Skype users at much lower rates than if made as a normal cellular call. The key technology partners to develop the 3 Skypephone are iSkoot and Qualcomm, both of whom stand to gain nicely should this partnership blossom.

Although iSkoot’s platform brings mobility to Skype, it must be noted that these calls are not truly mobile VoIP. There is a VoIP connection to Skype to enable the presence features, but the portion going over iSkoot’s server is an ordinary cellular call, and given the markets that 3 Mobile serves, these would basically be GSM calls. As such, there will likely be cases where 3 Skypephone’s rates for international calls may not be that much cheaper than what 3 Mobile’s subscribers would pay making these calls without using Skype.

There is increasing demand for mobile data applications beyond pure VoIP as well. There are a number of companies offering mobile IM capabilities, including TJAT, which offers a handset agnostic browser-based approach as well as an embedded SIP application. Tivi also offers some very impressive real-time video chat capability through video-capable handsets, which it demonstrated at the Fall VON show in Boston. Both companies are leveraging proprietary technology since current protocols and codecs are costly for mass deployment at this stage.

That said, 3 Skypephone is designed for mass market adoption, and bears Skype’s hallmark in terms of ease of use. In addition to being launched in time for the holiday shopping season, 3 Skypephone is affordably priced, and is available in 3 colors to ensure its appeal for all ages as well as both males and females.

It may seem that 3 Skypephone will benefit Skype more than 3 Mobile, especially in terms routing voice traffic away from their 3G network. However, in the markets served by 3 Mobile, international cellular calls are expensive, so there is little traffic at risk. As such, adding Skype should only make the pie larger, and encourage subscribers to use 3 Mobile for more calls than they are making today.

Not only will this serve to improve customer retention, but it lays the foundation for future services and revenue streams that will benefit both Skype and 3 Mobile. Two specific examples would be eBay's PayPal and MySpace. With a mobile payment application, 3 Mobile subscribers will have a new option for making purchases on the go, as well as conducting web-based ecommerce when away from their PC. Skype’s recent partnership with MySpace will bring social networking into the mobile arena, which creates new opportunities, especially for online advertising.

Stepping back from all this, there is a third disruptive element to consider. On its own, 3 Skypephone breaks new ground, but is also part of a bigger trend that is re-shaping the mobile telecom market. The launch follows Google’s Gphone handset and Linux-based calling platform, which in turn follows Apple’s iPhone. All three devices are different, but together represent a shift in the balance of power. Not only are these companies telecom outsiders, but each requires the carrier to adapt to them, which in itself is a major change to the status quo.

3 Mobile seems to be the exception so far, as they recognize the mutual benefits of working with Skype. If the companies can continue to drive subscriber demand with innovative handset designs and platforms, carriers will have no choice but to concede some power and embrace change. We expect this will be the outcome, in which case companies such as iSkoot and Truphone will be become attractive targets, not just for outsiders like Skype, but the mainstream handset vendors as well.

2. Fall VON 2007 Review

From VoIP’s earliest days, Pulvermedia's VON conference has been a bellwether for the impact of disruptive technologies on communications, especially telephony. VON is synonymous with VoIP, and Jeff Pulver has been a tireless evangelist, visionary, supporter and investor in dozens of companies in the space. In recent years, Fall VON has been based in Boston, and has often been a high point of the IP conference calendar, and the event of choice for major announcements and launches.

This year’s Fall VON, however, reflects some changing market realities that both investors and vendors need to consider carefully. The lifeblood of any trade show is the show floor. While VON is more than a trade show, both the number of exhibitors and participants walking about seemed lower than previous years. There may have been over 200 exhibitors, but many were small, and others seemed scaled back from what they were in the past. To be fair, the timing of this year’s show did not help matters. Not only did VON coincide with Halloween, but also the World Series, which happened to feature the hometown Boston Red Sox.

Several Tier 1 vendors were present, but not really prominent, namely Alcatel-Lucent, Nortel, Ericsson and Sonus. Many other “household names” one would like to see at the show did not exhibit, such as Cisco, Microsoft, Siemens and IBM, and VON regulars such as Broadsoft and Sylantro.

There are really two reasons why the exhibitor roster would be diminished. First is simply a lack of buyers to justify the investment of being there. Second would be the need – or desire – to support a community that is still emerging and will eventually be good for business. Our impression from the show was a bit of both. VON has never been sold as a marketplace for buyers and sellers – the appeal has been based more on providing a vision and roadmap for emerging technologies. VoIP has always been the core of the VON community, but today’s market is about building sustainable businesses rather than proving the technology’s viability.

We suspect that many VoIP vendors are shifting dollars elsewhere to attract new customers. It is also fair to say that early stage vendors have by now built up substantial customer bases, and also need to devote budget to support them. A number of these vendors are now hosting their own customer forums, and it would appear they are weaning themselves off the broader industry events to focus exclusively on customers and prospects in a controlled environment that excludes competitors. In our view this is a significant shift in the landscape that impacts all industry-based events, not just VON.

Over the past year, Pulvermedia has visibly shifted focus away from voice to video, in part to remain on the right side of these market trends. With the voice market maturing and video exploding, they have tried to position VON as an essential video event. From what we saw of Fall VON, they have done this quite well in terms of the speakers and panel sessions, where there was no shortage of leading edge content. However, the video market is too nascent to provide a pool of vendors who can afford to be exhibitors, which largely explains their limited presence on the show floor. As such, while VON can provide a strong focus on video content, the show cannot support it yet economically. In time, business models will emerge for video to better support this equation, but that is least a year away in our view.

With that said, there were other strong themes aside from video that demonstrate how VON is still very central to the trends shaping the communications landscape. On the service provider side, VON has expanded its coverage of mobility considerably, and there was a lot of attention paid to IP telephony solutions for the SMB market, especially of the hosted variety. The enterprise market was well served with tracks dedicated to Unified Communications, which we expect to be one of the top drivers across the board in 2008.

Finally, VON continues to cater strongly to the developer community with a substantial focus on Open Source, as well as a new feature, the Innovators Track. We applaud their efforts to introduce new approaches and topics, as conferences need to evolve to keep pace with their communities.

To this point, our analysis begs the question as to whether VON has lost its edge. Our views are mixed, not because we are on the fence, but because the picture is not clear. Some of the most interesting announcements made at VON came from Pulvermedia itself. Notable items included the formation of a VON Advisory Board, the launch of a “virtual event strategy” to bring VON to a wider audience, the acquisition of Open Source Telephony magazine, and a partnership with the Thomas Howe Company to help bring VoIP mashup developers into the VON fold.

Clearly, VON is not standing still, and Pulvermedia is trying to evolve and find the right balance between the disruptors who attract the visionaries, and the established players who bring the revenues and the customers. Listening to Jeff Pulver’s opening remarks underscored this challenge for us. His keynote address focused on the power of social networking, which is undeniably a trend with great business potential. However, like video, the business side has yet to emerge.

That said, the appeal of VON is very much about being in a place where the future can not only be imagined but also created. Unfortunately, the inspiration of Jeff Pulver’s enthusiasm for what may be possible did not carry far beyond his presentation. There was little evidence of these disruptive and innovative forces at the show – Google, Apple, Yahoo, Skype, Facebook, etc. Instead, many of the other keynote speakers were closer to the Voice 1.0 world that VON seems to be trying to move away from – AT&T, Sprint Nextel, Embarq, Alcatel-Lucent, etc.

As such, we came away with mixed signals from VON, and our conclusion is that their transition is still a work in progress. The VON franchise is in a highly competitive market, and to succeed they must be agile and adaptive, just like the technologies they are helping bring to the world. By next year, we should have our answer, and whatever the outcome, we expect the event will have a different look and feel.

3. Dialogic Acquires Cantata

On October 5, the IP communications sector saw yet another consolidation move. EAS Group, aka Cantata Technology, was acquired by Dialogic Corp. While financial terms of the deal were not disclosed, we see this as a good move for a couple of the related companies behind these names.

There are, in fact several companies connected to this deal, and a considerable degree of history involved. Starting with the buyer, Dialogic’s roots were in open system boards used to support CTI applications such as IVR and conferencing. As the company grew, Dialogic was acquired by Intel in 1999, and continued being successful under Intel’s brand. In mid-2006, Intel went through a major business rationalization, and in August, sold the Dialogic business to Eicon Networks. This represented Intel’s exit from the media processing and signalling market, including their own host media processing – HMP – software. The Dialogic business was a good complement to Eicon’s own products, making them a much stronger player in the market for enterprise telephony servers and gateways.

On the other side of the equation, privately-held EAS Group is the parent company of Cantata, which itself is an amalgamation of three Massachusetts-based companies. Cantata was formed in March 2006 as a merger between Excel Switching and Brooktrout Technology. Both companies were founded in the 1980s, with Excel being acquired by Lucent in 1999, and then taken private in 2003. In 2004, the third company came into the picture when Brooktrout acquired struggling media server startup SnowShore Networks. These three companies compete in different markets, and the envisaged synergies – embodied by the symphonic Cantata theme – never really materialized. Interestingly, Cantata was another bidder for the Dialogic business that went to Eicon when it was divested by Intel.

Under the Eicon umbrella, Dialogic has grown revenues in the area of $200 million, and is profitable and cash-flow positive. Dialogic has about 650 employees, and this number will increase by about 200 with Cantata. With this acquisition, the Cantata name will be dropped, and the three companies will revert to their original names, with a hyphenated Dialogic prefix. For example, Brooktrout will now be known as Dialogic-Brooktrout.

It is not yet clear how Dialogic will be any more successful with these three companies than EAS was under the Cantata banner. Excel and SnowShore are not core to Dialogic’s market focus, but will broaden their enterprise portfolio, and provide a modest entree into the carrier market. The real synergy comes from Brooktrout, which will enhance Dialogic’s standing in the enterprise communications market. Dialogic is the market leader for voice processing, competing primarily with AudioCodes and NMS Communications, and until now, Cantata. Brooktrout is a leader in fax processing, and adding them to Dialogic makes for a compelling one-stop-shop. Furthermore, Dialogic has an ongoing DID fax patent issue with Brooktrout, which now becomes moot.

Going forward, the payoff for Dialogic will be to leverage all these technologies to become an overall leader in media processing, covering voice, data and video. With a strong focus on R&D, they should have the resources to become more IP-centric and SIP-based. We expect some cost cutting to trim the 850 employees, but as a company with over $250 million in revenues, and IPO is always an option. TDM-based enterprise business will continue to carry Dialogic, but the future is IP. The sooner they can do this, the sooner they will be able to enter a promising market – Web-based platforms. Google, Yahoo and Microsoft are all well along the path to offering voice services, and are precisely the types of customers that could take full advantage of what Dialogic can now offer. The opportunity is there, and time will tell if Dialogic can do what EAS could not.

4. Art of the Deal: Cisco Acquires Navini

On October 23, Cisco Systems announced its acquisition of Navini Networks, and with it, their grand entrance onto the WiMAX stage. By 2007 standards, this deal was relatively small for Cisco, but addresses concerns that wireless was a weak link in their portfolio. This was a cash and assumed options deal, valued at $330 million, and represents a reasonable – but not outstanding – exit for Navini’s investors. Since being founded in 2000, Navini has raised about $160 million, yielding roughly 2x in returns.

On paper, the attraction for Navini is evident – an established vendor with a global base of over 70 customers. They have a strong product line of WiMAX base stations, modems, antennae, and adapters, with advanced technologies in the areas of “smart beamforming” and MIMO (multiple-input/multiple-output). These technologies are backed up by 13 active patents, with many others pending. It is also important to note that their base stations operate across several frequencies, ranging from 2.3 GHz to 3.6 GHz.

All of these factors will enable Cisco to compete on a global basis, especially in emerging markets, which we believe holds the best promise for this deal. Individually, broadband and mobility are very strong technology trends, and their paths are beginning to converge now. In many parts of the world, wireline infrastructure is lacking, and mobility will be the technology to enable broadband and voice services in general. On that front, Navini will clearly accelerate Cisco’s time to market. Cisco is aggressively seeking entry into high-growth markets, and with no dominant WiMAX vendor, they are now well-positioned in a space that is poised for growth in 2008.

The key for success is to enable carriers to provide inexpensive mobile broadband for their subscribers, especially in developing countries. This is what Navini’s technologies bring to Cisco – solutions that deliver faster data speeds and greater range of transmission. For carriers, this means offering more services to subscribers and lower operational costs.

In terms of growth, emerging markets are key to Cisco, as WiMAX offers fewer opportunities in developed markets, especially North America, where both broadband and wireless are widely available. Wireless is becoming common in emerging markets, but broadband-based data services offers better returns for carriers, so for them, WiMAX holds great promise.

The timing of Cisco’s deal would appear to coincide with an industry development that bodes well for WiMAX. On October 18, the ITU – International Telecommunications Union – announced that WiMAX has been added as the sixth standard for 3G. More specifically, this is the IEEE 802.16 standard, which is now included in the IMT-2000 family of radio interfaces.

This means that as carriers start migrating from 3G to 4G, they can now consider using WiMAX along with standards such as EVDO and LTE. One of Cisco’s strategic mantras is to focus on “market transitions”, and this ITU development has all the makings of one, especially on a global scale. Most developing markets are highly regulated and will only accept ITU-approved technologies. As such, the WiMAX market opportunity for Cisco became significantly larger with this announcement.

The North American market presents a very different scenario, as Sprint Nextel is the only major wireless carrier backing WiMAX, though Clearwire is also a pure-play. In the face of a declining subscriber base and aggressive service bundles from AT&T and Verizon, WiMAX has become a competitive imperative for Sprint Nextel. Despite their dominance in the North American networking market, the immediate appeal for Cisco to acquire Navini lies elsewhere.

Overall, we see this as a savvy move by Cisco. Acquiring Navini not only gives Cisco a foothold in a market with substantial upside, but it keeps them away from other vendors who are trying to establish themselves as early leaders. These are scenarios where Cisco has usually executed well, and the incumbent vendors – namely Alcatel-Lucent, Nortel and Ericsson – have good reason to now view Cisco as a serious WiMAX player.

Cisco recognized that early stage WiMAX vendors like Navini have struggled, as the market is still in “pre-WiMAX” mode, and without large scale deployments to prove the technology. Tier 1 carriers have been reluctant to deploy WiMAX with startups, but under the Cisco tent, Navini’s prospects are considerably brighter. Their current revenues are relatively small – around $50 million – and it could be argued that Cisco was able to acquire them at a favorable price because they lack the leverage needed to become a market force on their own.

Looking forward, we see this setting a valuation benchmark for the other WiMAX pure plays, namely Airspan Networks, Alvarion, Redline Communications and Soma Networks. All of these aside from Soma are public companies, and Alvarion appears to be the best positioned should Cisco’s move trigger further consolidation.

Among these vendors, Alvarion has the largest revenue base – considerably more than Navini – as well as market capitalization, and the least amount of debt. Airspan’s WiMAX revenues have not been healthy in 2007, Redline’s are quite small, and they just underwent a significant reorganization. Soma’s financial data is closely held, but we suspect their revenues are small as well. Furthermore, they have raised over $175 million to date, which is more than Navini – and given their small size, would not be as attractive a target as Alvarion.

5. Financial Highlights